This copy is for your personal non-commercial use only. To order presentation-ready copies of Toronto Star content for distribution to colleagues, clients or customers, or inquire about permissions/licensing, please go to: www.TorontoStarReprints.com

Deflation: The risks when prices keep falling

Most Canadians have no idea what deflation is. They have never lived through a period when the prices were dropping and don&rsquo;t know the dangers.

Deflation has rained pain on Japan's economy for almost 20 years. (KIM KYUNG-HOON / Reuters)

By Gordon Pape

Sun., Oct. 28, 2012

Most Canadians have no idea what deflation is. They have never lived through a period when the prices of just about everything were dropping. It hasn’t happened in this country since the Great Depression. But some senior policy-makers are concerned that we could be on the brink of a new deflationary period.

One of them is James Bullard, president of the Federal Reserve Bank of St. Louis. In July he warned that the United States was running the risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”

As The New York Times pointed out, his comments are especially significant because Mr. Bullard has long been regarded as a hawk on the importance of fighting inflation. That he now sees deflation as the greater risk marks a sea change in his attitude.

He’s not alone. It is widely believed that growing concern about the possibility of deflation was the driving force behind the Fed’s September decision to open the fiscal floodgates in an all-out effort to stimulate the U.S. economy and attack the country’s high unemployment rate. As part of that package, the Fed is spending US$40 billion a month for an indefinite period to buy long-term mortgage-backed securities and has pledged to keep interest rates at near-zero until at least the middle of 2015.

Along with other initiatives, the total stimulus package is worth an estimated US$1 trillion a year. These folks aren’t fooling around!

The word “deflation” was never mentioned in the minutes of the Federal Open Market Committee’s September meeting. That would have been a red flag to the markets and investors. Instead, the Committee said simply that “inflation over the medium term likely would run at or below its 2 per cent objective”. It’s currently right on that target in the U.S. while in Canada it was 1.2 per cent (annualized) in September.

Economists consider a little inflation to be a good thing. It’s a sign the economy is growing and people are spending. Deflation, by contrast, is bad.

What’s so terrible about gas going back to less than $1 a litre or the price of a quart of milk dropping 50 cents? For the answer, just look at the U.S. housing market, which has been experiencing what is known as a sector deflation since the crash of 2008. In some parts of the country, house prices have fallen by 50 per cent or more. Recently, a one-bedroom Florida condo was put up for auction on bid4assets.com with a minimum bid of only US$1. Some 51 bids were submitted with the winner paying only US$16,501. That’s what deflation will do.

Now imagine that scenario spread across the entire economy. Why would you buy a new car if it were likely to be cheaper tomorrow? Or a new TV set or sofa? Commerce grinds to a halt in such conditions. At the extreme, everything freezes because people refuse to spend cash on anything except the bare necessities.

The psychological impact of inflation is the exact opposite. There’s an incentive to buy now because people expect that at some point the price will go higher. Of course, if things get out of hand hyperinflation results and paper money becomes virtually worthless. That’s what happened recently in Zimbabwe where according to Wikipedia inflation reached 6.5 sextillion per cent in mid-November 2008. The country ended up abandoning its currency entirely and now uses foreign money such as U.S. dollars and South African rand.

So how do you protect your money in these situations? In a deflationary environment, there are only two good choices. One is cash. Even if you earn zero interest, your cash holdings will increase in value in purchasing power terms — you’ll be able to buy more with the same amount of money as prices fall.

The other winner will be government bonds. You’ll receive the full face value of the bonds at maturity (which will buy more since prices will have fallen). Plus you’ll receive interest payments along the way.

The 2012 Credit Suisse Yearbook looked at investment returns over the past 112 years and concluded that bonds generated the greatest returns in deflationary times. So the bull market in bonds may not be over yet. Much will depend on what happens over the next year.

But if inflation makes a comeback, bonds and cash are just about the last things you want to own. The buying power of your cash will gradually decline, while bond prices will sink as interest rates rise.

Credit Suisse says that stocks are not a perfect inflation hedge but do well “while inflation is within a low- to mid-single-digit range.”

Real estate will also perform well in that scenario.

We experienced runaway inflation as recently as the 1970s when both Canada and the U.S. were forced to impose wage and price controls. Mortgage interest rates soared to the 20 per cent range and bond prices plunged.

If that should happen again, gold and silver will be the safe havens. A smart strategy would be to buy the precious metals early, sell after a big run-up, and reinvest the money in depressed government bonds. A few brave investors made a lot of money in the late 1970s-early 1980s doing exactly that.

At this stage, we don’t know which way the economy will go. So my advice is to stay flexible, keep some cash reserves, and be ready to move quickly as conditions evolve. We’re not going to find a comfort zone any time soon.

Gordon Pape is the publisher of The Income Investor and the Internet Wealth Builder. His website is www.BuildingWealth.ca.

The Toronto Star and thestar.com, each property of Toronto Star Newspapers Limited, One Yonge Street, 4th Floor, Toronto, ON, M5E 1E6. You can unsubscribe at any time. Please contact us or see our privacy policy for more information.

More from the Toronto Star & Partners

LOADING

Copyright owned or licensed by Toronto Star Newspapers Limited. All rights reserved. Republication or distribution of this content is expressly prohibited without the prior written consent of Toronto Star Newspapers Limited and/or its licensors. To order copies of Toronto Star articles, please go to: www.TorontoStarReprints.com